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Effective Tax Rate Calculation

I am trying to understand the effective tax rate that is presented in the Two Year Report and the Five Year History.   If I take Total Income and multiply it by the Effective Tax Rate, the number does not equal Tax or Tax plus Alternative Minimum Tax.  What is the formula?
    From either report, take the Total Tax amount and subtract Total Credits (if any).  Divide the result by your Adjusted Gross Income.  Round off the answer to two decimal places and convert to a percentage, then compare your result with the Effective Tax Rate on the report.
    • Dave T315 provided the answer, now how do we question the logic of the calculation?  I understand the logic of starting with tax and subtracting credits.  However, why don't they add Alternative Minimum Tax?
    • The denominator is Total Income, not AGI.
    BurdenRatio is only off by one line

    TTX appears to use Form 1040,  line 55 / line 38.
    (tax years 2009 thru 2011.  the line numbers move around for earlier years)

    Whether you want to use other lines is up to you.
    • I will reiterate my earlier comment.  Since there is obviously no accepted method for the calculation, Turbotax should remove it.
    • SteamTrain: again line 38 is adjusted gross income which is rather different from taxable income, which was  mentioned in the initial answer by BurdenRation. But again using your "new answer" doesn't provide a percentage that matches TT calculation. In my case this time it is 7.39% vs 6.38%.

      I think we have to agree with Bob 777 comment that since there is no obvious interpretation of the number, it should be removed.
    • I haven't found any of the "answers" on this forum to be able to explain the calculation.
      Turbo Tax reports effective tax rate as 16.05.

      When I divide line 55 / line 38, (as BurdenRatio, SteamTrain suggest) I get 20.6%.
      When I use Dave315's suggestion of  :  (Total Tax amount - Total Credits) / AGI, I get 24%.

      In short, none of the answers on this forum seem to be able to decode the method that TT is using to compute this number.
      Clearly the existing "Effective Tax Rate" appearing on the front page is doo doo and should be removed.

      If Intuit wants to provide useful information on its summary form, it should provide the following (and document how it  calculates the # next to the result).   
      Tax rate:  Line 55 / Line 38
      Tax rate based on Total Income:  Line 61 / Line 22
      Total tax rates (including SS and Medicare taxes reported on W-2):   (Line 61 + Sum of W-2 lines for SS and Medicare) / Line 61.
      Incremental tax rate:   The rate at which the next dollar of income will be taxed.  This should include the effect of state income tax if any.

      Line #'s in the above suggestions are based on form 1040 for 2011:
    • Try line 44 (Tax) divided by line 37 (AGI).  This seemed to the effective tax rate that TT was using (it ignored the AMT I'm paying).  Agree that Intuit should define it in the report.  I believe the "effective tax rate" should be just line 61 (total tax) divided line 22 (total income).  This is for 2011 1040.
    • csmatrix, your suggestion doesn't work either: 10% vs 6%
    • I have only used TT 2 years (non-consecutive) so I don't have 2 or 5 year reports, but feel I may be able to help.

      The effective tax rate is supposed to be calculated as TOTAL TAX (the total amount of tax you need to pay for the year less any tax credits)  divided by TAXABLE INCOME (the portion of your income you are to be taxed on), then multiplying by 100 to get the percentage. Taxable income is total income less deductions and exemptions. This is line 43 on my 2011 form 1040. This line is then used to calculate your tax liability. Tax credits would reduce the liability, resulting in the total tax to be paid for the year entered on line 61. In essence, it should be line 61 divided by line 43, then multiplied by 100.

      Unfortunately, TT calculated my effective tax rate (as noted on the summary page both years) as TOTAL TAX (line 61) divided by ADJUSTED GROSS INCOME (line 37), ignoring standard/itemized deductions and exemptions (which you don't pay tax on). This will always give you a lower percentage, or rate, making TT users happy to have paid so little tax.

      I assume that the report/history might average this (incorectly calculated) rate over the span of 2 or 5 years. Personally, in order to compare my tax rate with that of the current presidential nominees, I want to know the correct rate, so I'm just creating my own spreadsheet...with correct calculations.
    • ddahlquist4,
      Thanks for trying, but your suggestion is not even close in my case: 15% vs 6%.
    • The denominator is Total Income, not taxable income.
    Let's think about your answer in the context of that "effective tax rate" means to me.  If I am married and have $100K in gross combined income, but then subtract $3000 from prior year capital losses, subtract the amount of income earned from municipal bonds, and also exclude 15% of my social security income, my adjusted gross income drops to $77K.  Now tax breaks for itemized deductions and the personal withholding allowance further reduce the amount of income that is actually taxed.  My marginal tax bracket rate might be 25%, but don't forget that the first increment of income is taxed at 10%, the next increment is taxed at 15%, while the last dollar I earn is taxed at 25%.  Additionally, dividend income and capital gains last year were taxed at either 0% and/or 15%.   After I compute the tax liability on my taxable income, I get to reduce my tax bill by tax CREDITS that I might have received for a home purchase, or education expenses.

    What if there were no tax breaks, no allowed deductions, and no tax credits?  What if I paid an income tax on every dollar earned at a flat rate (not a graduated, or, progressive rate)?  What if I only paid $5250 tax on my $100K of gross income?  Would you be comfortable saying that my rax rate was 5.25%?

    Now, when the blended rate after the "loophole" deductions that are in the tax code, gives me a tax bill of $5250 on the same $100K of gross income, my tax bill is the same as it would have been if there were no tax deductions, no tax breaks, and all my income was taxed at 5.25%.  In other words, my "effective" tax rate (that TT calculates) is a mere 5.25%, even though my marginal bracket rate is much higher.

    Does this clear up the question of what I think TT calls the "effective" tax rate. 
    What the comments in this post point out is that there is no standard definition of "effective tax rate."  For example,

    1.  Should it be based on total income, adjusted gross income or taxable income?  Should it include exempt income?  For example, should it include social security received or only the taxable portion?  How should the combat pay exclusion be handled?

    2.  What is meant by tax, in tax rate?  Does it just mean normal taxes, or should AMT be added?  How about other additions to taxes like the premature distribution penalty on a deferred plan?  If so, shouldn't other penalties treated as an addition to the tax (like the delinquency penalty) also be included?  Should taxes include unreported FICA and Medicare taxes on tips that are included on the tax return.  If you're going to include those, wouldn't you also include FICA on the W-2.

    3.  How are credits to be handled?  Should taxes in the computation exclude the homebuyer credit or include it.  How about in the next 15 years when the credit is repaid?  Should EIC, which isn't really a tax item but is more in the nature of social welfare be excluded or included?  How about non-business credits like energy credits?  What should be done with an item such as foreign taxes paid, which can either be a tax credit or a deduction?

    So long as there is no standard definition in the statute for "effective tax rate", then the definition of your effective tax rate is whatever you want it to be.  If you don't like Turbotax's definition, use your own.  My only expectation of a software program, especially as there is really no use for the number, is that whatever method is used, it be used consistently from year to year.  Even then, however, you're comparing a nonexistent standard to a nonexistent standard.
    • If one accepts BWA's comment about there being no standard definition of effective tax rate, then Turbotax should not include it in the reports.  It should be removed.
    • Why the guessing game? Either list the components of the calculation above the percentage or remove the calculation.
    • It is a bit of a guessing game...I really just wanted a "simple consistent metric" .. like  Tax divided by Income.  I was surprised to see my effective tax rate had gone up though my earnings and tax had stayed roughly the same.  I noted in the 5 year comparison I was able to calculate the effective rate myself for 3 of the years using my "presumed" formula and arrive at the same answer as TT.  For two of the years I can not...and I had no clue why they are not in line with the others.  I'm happy they include the metric...but I should be able to get a definition of their calculation in the software.
    • The calculation should either be removed or modified to match what would be a more sensible definition.  I think a sensible definition is one's tax liability divided by ones total income....I earned X, the government took Y, so my effective tax rate is Y/X.
    • I don't think the answer provided by Dave315T is correct either. I tried applying it to my return and it doesn't work. The closes I can come to TT result for now is (Tax after credits) / (Total income). I'm curious to find the correct answer.
    • Let's be clear - TT is trying to show as a low an effective tax rate as possible to make us feel they are doing a really good job of keep our taxes really low!  Totally agree with the comment that it should be removed or made conservative/more accurate.....Total Tax / Taxable Income
    • No one has even suggested the obvious ... Intuit is working with the IRS to generate the appearance of lower tax rates.  To these boneheads, perception is reality.
      It is funny that in every case the calculated number (by Intuit) is lower than the actual number.  Feels like a straw-man to me.
    • Another way to try to figure out how the effective tax rate is calculated is to try reversing the calculation.  In my 2011 Summary, I took the Total Tax and divided it by the Effective Tax Rate (converted from a percentage to a decimal).  The number came very close to the total of my AGI and Total Payments/Credits.
    • Seems that DaveT315 answered it. More specifically, it's the bottom line in the "Tax and Credits" section of Form 1040, line 55, divided by AGI, line 37. It's the effective INCOME tax rate, a word which it would make sense to add in my case, at least. Having to pay self-employment tax nearly doubles my "effective tax rate."
    • TvA, DaveT315 answer doesn't work in my case.
    The Effective tax rate as calculated by TT appears to be:
     Line 56 of Form 1040 divided by Line 39.  
    In other words, ("Tax, Total" after credits)/("Income, Taxable").
    • The answer submitted by BurdenRatio is not even close. First of all the line numbers are incorrect. There is no amount in line 39, and 56 is Self-employment tax. Going by his/her description, total tax after credits would be line 61 of 1040, and taxable income would be line 43.

      In my case the ratio for those two lines is 25.65% while Turbotax reports 6.38%
    Effective tax rate is computed based on the ratio of tax to income.

    Income is the adjusted gross income from Form 1040, line 37. However, if there are lump-sum distributions from qualified retirement plans and special averaging or capital gain treatment is selected on Form 4972, the taxable amount of the distributions is added to the adjusted gross income. Also, if the distributions include net unrealized appreciation in employer's securities, and the option is selected on Form 4972 to include this in the tax calculation, the amount of the net unrealized appreciation is also added to the income.

    Tax is calculated starting with the tax on line 46 of Form 1040, including the alternative minimum tax, but not including the recapture tax from Form 8863 (Education Credits) or the tax from the IRC Section 197(f)(9)(B)(ii)election for an additional tax. It does include the tax from Form 8814 and Form 4972. The smaller of the nonrefundable credits shown on line 54 of Form 1040 or the remaining tax is then subtracted. The other taxes shown on lines 56 through 59 on Form 1040 and taxes in Additional Other Taxes Smart Worksheet on Form 1040 are not added to the tax. Finally,the Earned Income Tax Credit, the Additional Child Tax Credit from Form 8812, the Refundable Education Credit from Form 8863, the First-time Homebuyer Credit from Form 5405, the Fuel Tax Credit from Form 4136, the Credit for Prior Year Minimum Tax from Form 8801, the Health Coverage Tax Credit from Form 8885, the Credit for U.S. Tax Paid to the Virgin Islands from Form 8689 and other payments are subtracted. Note that these eight credits are refundable tax credits.

    The effective tax rate is the tax divided by the income. Because of the refundable credits, the resulting net tax could be negative if the amount of these credits is greater than the tax liability. As a result, a negative effective tax rate is possible.

    If the income as defined above is zero or less, the effective tax rate is set to zero.

    Right click on the Effective Tax Rate field on the Tax History report.  Click on About Effective Tax Rate

    • Unfortunately what you are saying does not correspond to TT's tax rate. So there must be a problem somewhere.
    • Try beginning with Total Income as shown in the Two-Year Comparison or the Tax History. Again, this is NOT necessarily AGI. Do you believe this number is somehow wrong based on the explanation as posted by doninga?
    • Calculates exactly according to my tax history report for 2012.  It does use the AGI from Line 37.  Of course I did not have any form 4972 exceptions.
    • Doninga, the fact that it worked in your case does not prove that it works in every case. Since it didn't work in my case (and we are talking 6% vs 15%, not just rounding errors) it's the proof that there must be other numbers involved.
    The effective tax rate is your tax, net of credits, divided by your total income as shown in the Two-Year Comparison and the five-year Tax History..

    Because the earned income tax credit and the fuel tax credit are refundable credits, the resulting net tax could be negative if the amount of these credits is greater than the tax liability. As a result, a negative effective tax rate is possible. If the income is zero or less, the effective tax rate is set to zero.

    TurboTax only computes the effective tax rate for the current year. However, if you have used TurboTax in previous years and always transferred in your prior-year return files, then you can see the prior-year effective tax rates in the Tax History summary (2008-2012 for TurboTax 2012).

    Since the calculation is consistent across years, the statistic, as presented in Tax History, can be useful for tracking how your tax burden has changed over time.
    • I don't think that's the way TT calculates it. At least not in my case.
    Bob, why do you need to know?  The effective tax rate is not used anywhere on your tax return or to compute your tax liability.  Rather, it is Turbotax's computation from tax return data that is there for your information only.  If you want to compute it in a different manner, you are certainly welcome to do so.  I suspect it was done the way it is in Turbotax because some programmer was asked to add it to the program without much thought or direction on how complex or complete to make it.
    • Why do I need to know?  The calculation is displayed in at least two reports and, it annoys me that it understates my actual effective tax rate.  If they are not going to do it in a logical manner, I would prefer they remove it or provide the option to not have it in the report.  Also, in perusing previous questions and answers to this forum, it appears that other users have had similar questions.
    • It is just wrong based on the logical definition.    Agree it should be removed.
    • Agree with the comment about removing it.  I was reviewing my 2011 federal and was shocked to see my effective tax rate so low.  I find it unnerving that any calculations in a final report are wrong.... even if its not of use to the IRS, its a helpful data point for planning purposes.  Thanks for the question and answer... helpful to know others too have the same problem.
    • I agree w/ Bob, and thanks, Bob for finally revealing why my effective tax rate seemed so low...  the AMT was throwing it off.  Not really a useful metric if you're paying a ton in AMT.  The calculation in TT should just simply be Total Tax / AGI and call it a day.
    • I agree with Bob.  The effective tax rate as calculated by Turbo Tax is misleading and should be eliminated or changed to something more realistic like Total Tax divided by Adjusted Gross Income, or even Total Tax divided by Taxable Income.
    • Intuit, are you listening?  Before finding this post, I just spent a good half hour figuring out that the nonsensical effective tax rate reported by TT was not based on actual tax paid but rather was (actual tax paid - AMT)/AGI.
    • Note this rate also ignores any "special cases" (like self-employment, 10% early withdrawal penalty for retirement funds, etc..  I'm not sure why - those are monies that I had to pay to the government; they are without a doubt "effective."
    • I fully agree with all the comments.  If you going to print an effective tax rate, make it correct. It doesn't take into account the AMT, but does take into account the Foreign Tax Credit!  They should remove it or make it Total Taxes (line 61) divided by AGI.  An important rate they should include is the marginal rate for additional income and/or deductions.